The 4 Types of Stablecoins (and What Actually Holds Each Peg)

TL;DR

• Every stablecoin makes the same promise, one token equals one dollar, but there are only four designs for keeping it: fiat backed (USDC, USDT), CDP (DAI), synthetic yield (the Ethena model), and algorithmic (Terra's UST).
• Each design is a different bridge across the same river, and each is held up by something different: a company's reserve accounts, locked crypto collateral, offsetting positions, or pure belief.
• Who is paying? For fiat backed coins, you are, quietly: the issuer keeps the yield your reserve dollars earn. That is the business.
• UST's collapse in May 2022, where tens of billions of dollars evaporated in days, was a design failing under load, not an attack. The algorithmic bridge carried nothing but confidence.
• Three questions sort any stablecoin you will ever meet: what is the reserve asset, what is the redemption path, and who earns the float.

What are the four types of stablecoins?

There are four types of stablecoins, defined by what stands behind the token: fiat backed coins hold dollars in company accounts, CDP coins are minted against locked crypto collateral, synthetic dollars hold offsetting positions that cancel each other out, and algorithmic coins hold nothing but a swap promise.

If stablecoins are new to you, start with what stablecoins are, the beginner primer that covers why digital dollars exist and what people use them for. This article goes one level deeper: not what a stablecoin is, but what is holding yours together, and who does that work every single day.

Because someone does. A stablecoin's price does not sit at one dollar out of habit. Draw the promise as a chart: a line at one dollar and a narrow band around it. A stablecoin earns its name by walking inside that band, day after day, through every storm. Falling out of the band has a name too: a depeg.

Here is the picture that carries this whole article. The band is a river crossing, and every stablecoin is a bridge holding its token at one dollar. Four bridge designs exist, four engineering answers to the same load. Let's walk all four.

How do fiat backed stablecoins like USDC and USDT hold their peg?

Bridge one is the simplest engineering: a warehouse. A company holds dollars and dollar equivalents in reserve accounts and issues one token per dollar received. Send Circle a dollar, one USDC is minted. Redeem one USDC, and a dollar comes back out. USDC is run by Circle; USDT is run by Tether. The design's name follows the function: fiat backed.

But here is the part most explainers get wrong: the vault alone does not hold the peg. Traders do. Suppose USDC slips to 0.98 on an exchange. The Fed does not step in; USDC is a private company's token, not government money. Circle does not buy coins back with its own profits either. It only has to honor redemptions at 1.00, because two cents of profit per coin summons arbitrageurs: buy at 0.98, redeem with Circle at 1.00, repeat until the gap closes. Above a dollar the trade runs in reverse: mint at one, sell higher. The peg is not held by decree. It is held by arbitrage against a redemption promise, automatically, all day long.

Now the question you should ask of every design in this article: who is paying? For fiat backed coins the answer is you, quietly. The issuer takes your dollars, parks them in reserve assets that earn interest, and keeps that yield for itself. You hold a token that pays you nothing; the issuer holds a reserve that pays it plenty. The float is the business. That is not a scandal, it is the deal, but you should know you are on the paying side of it.

What is the trust assumption? A company and its banks. You are trusting that the reserves exist, that the accounts stay open, and that redemption keeps working. Fiat backed coins live inside the banking system, and their issuers are companies that can freeze funds or be compelled to. That exposure is exactly what the next bridge was built to avoid.

How does a CDP stablecoin like DAI work?

Bridge two removes the company entirely. Instead of dollars in a bank, the reserve is volatile crypto locked in a smart contract vault. Lock ETH worth more than the dollars you want, then mint stable coins against it, always fewer than the vault is worth. The design's name is a CDP, a collateralized debt position, and DAI, from MakerDAO, is the standing example.

If you have read how DeFi lending works, this machine should look familiar: it is the pawnshop in reverse. Rather than borrowing someone else's dollars against your collateral, you manufacture your own dollar against it. The coin is born as debt, backed by locked collateral worth more than the coin.

What holds this peg day to day? Two machines you may already know. Overcollateralization keeps every DAI backed by more than a dollar of value, so the coin is never a claim on hope. And when a vault's collateral thins toward the danger line, the liquidation machinery covered in DeFi liquidations explained holds the floor: bounty hunters close weak vaults before the backing can fall below the debt, keeping every coin covered.

The trade is straightforward. You escape the company and its banks; nobody can freeze DAI's reserve accounts, because there are none. In exchange, you take on code, price feeds, and liquidation mechanics as your new dependencies. Trustless-er than a bank account, and leaning on everything the lending stack has to get right.

What is a synthetic dollar, and how does the Ethena model work?

Bridge three is the counterweight, and it is the design most people have not sat with. It holds no bank dollars and locks no extra collateral. Instead it holds crypto and simultaneously shorts the same crypto using perpetual futures.

Work through what that does. If the price of the crypto rises, the coins gain value and the short position loses the same amount. If the price falls, the reverse. The two legs cancel, and what remains sits still, worth a dollar, whatever the market does. Stability manufactured from two positions that offset.

Then comes the part that made this design famous: the yield. Perpetual futures pay funding, a periodic payment between longs and shorts, and when the crowd leans long, shorts collect it. This bridge is the short, so in those conditions funding income flows in and can be passed to holders. That is why a synthetic dollar can pay a yield with a nameable, legitimate source, which is rarer than it sounds; where DeFi yield actually comes from is a short list.

Ethena runs the model everyone points to, and the honest description includes its weather dependence: the design's solvency inherits whatever the perp market is doing, because funding can thin out or invert. Elegant, real, and exposed to its own particular sky. The name for the design: a synthetic dollar.

What happened to algorithmic stablecoins like UST?

Bridge four held nothing at all, except a promise. An algorithmic stablecoin is backed by no dollars, no collateral vault, and no hedged positions. Instead, the system promises that you can always swap one stablecoin for one dollar's worth of a freshly printed sister token. The sister token absorbs all the volatility; the stablecoin, in theory, stays still. Terra's UST was the giant of this design, with LUNA as its sister token.

Read what follows as engineering, not villainy: a bridge carrying a load, and then failing to.

For a long stretch, the swap promise worked. Selling pressure on UST minted sister tokens, buyers absorbed them, and the peg held. But notice what the real reserve was: confidence. The design only worked while people wanted the sister token.

Then redemptions got heavy. Sister tokens were minted faster than buyers wanted them, so the sister's price sagged, which meant each subsequent redemption printed even more of them. The reserve was draining, and the reserve was belief.

In May 2022, confidence broke entirely. The sister token hyperinflated toward worthless, and there was nothing left to swap into. Tens of billions of dollars evaporated in days. It was not an attack, whatever the retellings say. It was a design meeting a load it could not carry: a bridge whose only material was the crowd's willingness to keep standing on it.

The lesson is not "algorithmic designs were early." The lesson is that this design must carry, alone and unbacked, the exact load the other three bridges carry with reserves, collateral, or hedges.

How do you tell which type a stablecoin is?

Here is the field guide, compressed:

And here are the three questions that sort any stablecoin you will ever meet, including ones launched after this article was written:

1. What is the reserve asset? What actually sits behind the coin: bank dollars, locked crypto, offsetting positions, or nothing but a mint promise.
2. What is the redemption path? How does the coin turn back into a dollar, and who honors that swap when things get tense.
3. Who earns the float? Somebody is making money on the reserves or the mechanism. Name them, and you have found the business under the bridge.

The answers name the bridge, and the bridge names the load limit. That is the entire skill.

One test of the skill. A new stablecoin appears, and holding it pays 15 percent. Nothing else disclosed. The wrong questions are "is 15 percent too high to be safe" (the number alone answers nothing) and "has it held its peg so far" (UST's chart was flat right up to the week it was not; a held peg is history, not engineering). The right question is where the yield originates. Reserve float means the issuer is sharing what Circle keeps. Funding income means an Ethena style engine, solvent in perp weather. Token emissions mean the yield is printed, and May 2022 taught what that rhyme costs. Name the payer, then the bridge, then decide.

If fiat backed coins dominate, are the other designs dead ends?

No. Fiat backed coins carry most of the money today, but winning volume is not winning every trade-off.

Every bridge charges a different toll. Fiat backed coins lean on a company and its banks: the issuer can freeze funds or be compelled to, exposure the CDP design exists specifically to avoid. CDPs trade that away for collateral and liquidation exposure. Synthetic dollars trade both for perp market weather. And the algorithmic bridge asked belief to carry everything, which is why it is the graveyard bridge of the four.

Sorting a coin into its design tells you which toll you are paying. It never tells you which coin is best, because no bridge is free.

If you want to build this instinct rather than memorize the table, the stablecoin designs checkpoint of Your First 90 Days in DeFi, our free interactive course, has you sort USDC, DAI, UST, and the Ethena model into their bridges yourself, and then hands you the 15 percent stranger. The first three checkpoints need no account.

Related questions

What is the safest type of stablecoin? No design is free of risk; each just concentrates it differently. Fiat backed coins carry issuer and banking exposure, CDPs carry collateral and liquidation exposure, synthetic dollars carry perp market exposure, and algorithmic coins carry confidence exposure, which history has priced the most brutally.

Is DAI backed by dollars? No. DAI tracks the dollar, but its reserve is crypto locked in MakerDAO vaults, always worth more than the DAI minted against it. Tracking the dollar is every design's goal; it never tells you what stands behind the coin.

Why did UST collapse? UST was backed only by a promise to swap it for a freshly minted sister token, LUNA. Heavy redemptions printed sister tokens faster than buyers wanted them, confidence drained, and in May 2022 the sister token hyperinflated toward worthless, taking tens of billions of dollars with it. A design failure under load, not an attack.

Who keeps the interest earned on USDC reserves? Circle, the issuer. Your dollars sit in reserve assets that earn yield, and that yield is the issuer's revenue, not the holder's. The same is true of Tether and USDT. The float is the business model of every fiat backed stablecoin.

How does a stablecoin recover after slipping below one dollar? Through arbitrage against redemption. If the coin trades at 0.98 and can be redeemed for 1.00, traders buy it cheap and redeem it at full value, and that buying closes the gap. A peg without a credible redemption path has no such repair crew.

Are synthetic dollars the same as algorithmic stablecoins? No, and this is the pair people confuse most. A synthetic dollar holds real offsetting positions, crypto plus a short, and earns funding income. An algorithmic coin holds a swap promise into a sister token, with nothing canceling anything. One is hedged; the other ran on belief.

Where to go next

You now know the four bridges: a warehouse of dollars with a redemption promise, a vault of crypto with a liquidation floor, positions that cancel and get paid by funding, and a promise that ran on belief until May 2022. One load, four ways to carry it, and three questions that sort every coin into its design.

From here, two directions deepen the picture. The CDP bridge stands entirely on the lending machinery, so read how DeFi lending works and DeFi liquidations explained to see the floor under DAI. And whenever any stablecoin offers you a yield, run it through where DeFi yield actually comes from before you take it.

Or walk the machines in order, hands on: Your First 90 Days in DeFi covers the whole river, one bridge at a time. It is free, and the first three checkpoints need no account.